Using Market Data for a Variety of Institutions

There are at least three types of institutions for which we believe market
data will prove helpful in the short run: large complex banking organizations
(LCBOs), institutions with publicly traded debt or equity that are not
LCBOs, and institutions with a significant amount of nontraditional activities.

LCBOs. Market data might prove useful for LCBOs for
three reasons. First, these institutions face the greatest level
of scrutiny by market participants. These institutions have
the most frequently traded debt and have widely held and frequently
traded equity. Many LCBOs also provide relatively high levels
of disclosure. Market participants thus should be able to generate
high-quality signals regarding the condition of these banks.
Second, these institutions rely on capital markets for funding
and make sophisticated use of market data in their operations
(for example, capital modeling). As a result, market prices
heavily influence these institutions and they take such signals
seriously. Finally, the complexity and scope of activities of
these institutions make their supervision challenging. Supervisors
should therefore welcome assistance from millions of market
participants.

Two factors mitigate the benefits of using market data in the
LCBO context. First, LCBO supervisors have constant access to
nonpublic information on LCBOs and already make frequent assessments
of their soundness. Market investors may therefore have less
new information to add. Second, the complexity that makes understanding
the institutions a supervisory challenge also applies to market
participants.

NonLCBOswith market signals. LCBOs receive the
highest level of scrutiny by both markets and supervisors. Further
down the size and complexity spectrum, both the depth and the
frequency of analysis begin to taper off. However, there appears
to be a group of midsize institutions that are followed fairly
closely by market participants, have debt or equity that trades
fairly frequently, but are not under continuous supervision
by the banking agencies. For these institutions, signals from
the financial markets may add timely, fresh assessments to supplement
the less frequent collection of supervisory information.

Nontraditional institutions. Banking organizations have
increased their nontraditional activities over the last two
decades, and financial modernization legislation could further
encourage this trend. This shift could lead the Federal Reserve
to supervise more firms that have relatively small amounts of
their activity covered by traditional supervisory information
and amenable to traditional analysis. The Federal Reserve and
other banking regulators are responding by increasing their
ability to analyze nontraditional activities. However, banking
regulators could benefit by relying more on market data for
such firms, leveraging the assessments of experienced market
observers. Although changes in the banking business also present
challenges for market participants, market data may provide
summary measures of condition that are more robust to industry
evolution.